The Hindu Business Line : Scam secret: Suspended disbelief

Illusionist Doug Henning famously said, “To create good magic, we must be able to get our audience to suspend their disbelief.” Several financial illusionists such as Ketan Parekh, Kenneth Lay and Bernard Madoff would agree that suspending the investor’s disbelief is the way to run a successful scam.

While most frauds come down to being a zero-sum game with one person getting paid a higher price for his or her assets at someone else’s expense, the means to this end could be different. A study of scams shows that the means can range from ramping up the price of the asset to hyping up its prospects to gaining an unfair edge on information.

Modus operandi

Parekh and Mehta successfully jacked up prices of stocks, while Madoff (modelling on Charles Ponzi) reeled in investors by promising very high returns. In the scam uncovered last week, Galleon Fund founder Raj Rajaratnam is alleged to have had information about companies, which helped him foresee event-led stock price swings and profiteer.

Whatever the means, most scams take on one of the following avatar’s. Avatar number one is price rigging – an activity where asset prices lose their moorings in intrinsic worth or productivity. All that matters is that someone is willing to pay a higher price for an asset than the price it trades at today; the Greater Fool’s theory, as economist John Maynard Keynes put it.

Consider the infamous (Ketan) Parekh scam. He would borrow money from banks to transact in a company’s shares and drum up volumes in the stock. This would cause its price to rise, luring other investors. Parekh would then sell out at higher prices, leaving the investor holding overpriced shares.

The companies whose prices he manipulated included Himachal Futuristic, Zee, Satyam and DSQ among others.

Another form scams can take is hyping how lucrative an asset’s yield will be. The dotcom bubble is an example of what happens when the potential of a business is exaggerated so much that investors end up paying an exorbitant price for the asset.

In the late nineties, Internet and telecom companies were having an increasingly significant effect on the way people lived and did business. However, hype about the coming dotcom era made sure that several companies that had no sales or were losing money commanded staggering valuations for fairly simple businesses such as selling pet food online (Pets.com had Rs 1,600-crore market cap at one point).

By overstating the potential profitability of an asset, the promoters and early investors were able to cash in on an idea. Closer to home, chit funds that go bust also work on the lines of a Ponzi scheme, with new fund entrants subsidising the funds withdrawn by earlier bidders.

Taking this a notch higher are accounting scams – which tinker with the metrics of productivity, that is, the accounts that measure how profitable a business is. These have usually revolved around managers making a business appear a great deal more profitable than it is. Enron is a famous example of such a scam.

The company used abstruse accounting methods to cover up its mounting losses. It recognised unrealised earnings from fictitious sales transactions with entities created by the company. When Enron’s methods were exposed, the stock crashed from $90 to 60 cents in 16 months.

The Enron episode also opened a can of worms involving executives who sold their shares before the scam was uncovered, bringing us to the next scenario – asymmetric information.

Such a scam occurs when a market participant acquires through unfair means information not available to others, creating a situation similar in a game of cards, where one participant knows which cards everyone else holds.

When a person has such information, which will affect the company’s share price, he can potentially profit from the data.

The recent allegations levelled against Rajaratnam, whose Galleon hedge funds are said to have made illegal profits of more than $25 million, pertain to the fund obtaining inside information about several companies, including Google, Sun Microsystems, AMD and Hilton. The fund is said to have made money by obtaining basic information such as quarterly earnings figures and news on imminent deals ahead of the market.

Whatever their form, all scams have one thing in common. They involve portraying a prettier picture of an asset, its environment or its price, and investors are cajoled into buying based on this illusion.

If scams and accounting scandals are breaking out often, why are regulators unable to stop it? Well, the regulators cannot do much.

Regulators and their agencies have to peer into the rear-view mirror while laying out the law. Whenever a scam occurs, both investors and regulators are put on guard against that particular kind of scam. But the next one turns out to be quite different, exploiting a different loophole in the law.

The US serves as a good lesson in the evolution of financial regulation. When the stock markets crashed in 1929, the Securities and Exchange Commission was created to oversee and regulate equity markets. But that didn’t stop the mushrooming of hedge funds, which were outside the ambit of SEC. In 1997, for instance, hedge fund Long Term Capital Management imploded after making several highly leveraged bets on esoteric scenarios and instruments, in the process almost bringing down the financial system.

In another case, the Glass-Steagall Act was passed to separate investment banks from commercial banks in the US to avoid a recurrence of the 1929 market collapse. However, it was repealed in 1999, prompting several banks to load up on financial instruments based on home loans of questionable quality. By 2008, several institutions such as Bear Sterns, AIG and Citibank found themselves on the brink of collapse due to the same mortgages, and required Government bailouts to survive.

Regulators, by virtue of the urgency with which they are required to act, cannot place a fielder on every inch of the boundary. When they move one fielder, they are opening potential gaps for an expert batsman (the scamster) to score. The investor’s cause is not helped when the boundary is thin and subject to interpretation.

Rules can disincentivise bad behaviour, but the definition of bad behaviour remains subjective and will always remain so.

With the limited hedge regulation provides, the investor has to fall back on prudence. History is filled with examples of investors being suckered into abstruse schemes by fixating on returns or an idea without questioning the dynamics behind them. Only by questioning can one hope to avoid the pain from losing in scams, which are as inevitable as it is human to err.